Profiting from TRANs

How to make the most of short-term borrowing

The economy's rapid decline has affected every municipal budget. Cities and counties that once were flush with cash are now spending their reserves. Many jurisdictions will face a cash-flow deficit in their general fund sometime in the current or coming fiscal year. Some can cover their shortfalls by taking money from one fund to lend to another (known as inter-fund borrowing). However, there may be an alternative: issuing short-term tax and revenue anticipation notes (TRANs), sometimes called cash-flow borrowing notes.

TRANs are issued by state and municipal governments to finance short-term cash flow deficits that occur due to irregular receipt of tax and/or revenues (e.g., property taxes), and to help fund working capital requirements for operating expenses.

Short-term tax-exempt money is cheap nowadays. The Federal Reserve's recent actions to suppress overnight interest rates, coupled with investors' flight to liquidity, have resulted in historically low short-term rates and an influx of cash into money-market funds. This increased demand is bolstered by the diminishing supply of short-term paper due to the collapse in variable-rate demand note volumes, given the lack of available credit and liquidity facilities in that market. As a result, demand in the short-term tax-exempt note market is expected to be vibrant this summer. Plus, there may be a way to make a little money for your taxpayers in the process.

As most readers know, two decades ago the Treasury revised its arbitrage regulations to prevent municipalities from profiting from reinvesting (tax-exempt) municipal bonds in taxable paper. Any excess earnings or "arbitrage profits" must be rebated back to the Treasury. There is, however, an important exception from the rebate if the proceeds are spent for short-term, cash-flow borrowings.

Here are some general guidelines and strategies for the issuance of TRANs:

1. One year limit. Federal "safe harbor" tax regulations stipulate a maximum 13-month maturity for cash-flow borrowing notes (TRANs). Issuers are also required to make an interest payment within a 12-month period and to repay all TRAN principal and interest with the current year's revenues. The primary investors for TRANs today are tax-exempt "money market" mutual funds, which are effectively limited by the SEC's 2a-7 regulations to buying maturities of 12 months or less. Given the lack of reinvestment opportunities in this current market, the advantages of extending the final maturity beyond 12 months are very limited.

2. Borrow no more than your projected cash-flow deficit. The arbitrage regulations are very clear about this: You cannot borrow more than you reasonably expect to need -- that is, the maximum aggregate general fund cash flow deficit plus a working capital reserve. Working capital reserve is typically defined as the lesser of 5 percent of operating expense, average ending monthly balance or average first and last month cash balance. Your bond counsel's tax partner can help you determine the maximum amount you can borrow to avoid any appearance of abuse.

3. Detailed cash flows and accurate projections are essential. The documentation requirements are quite substantial nowadays, so if you have not done one of these recently, be prepared to develop detailed cash flow projections and to provide comprehensive documentation. Many TRAN issuers retain a professional financial adviser to help them prepare the various schedules just to make sure they have verifiable compliance.

4. You've gotta prove it! Previously, it was sufficient to have reasonable expectations of a cash-flow deficit, but that invited so much abuse that the Treasury department finally started requiring a compliance test to determine that the amount borrowed could be reconciled with the actual maximum cash flow deficit amount borrowed. If you fail this test, your issue will violate arbitrage rules and you will be liable for paying your profits to the IRS, plus other potential penalties to make sure you never even think of doing this again. Cautious finance officers should print out the accounting report that verifies the date that they reached their maximum aggregate cash flow deficit.

5. Timing, sizing, and reinvestment strategy are important. In addition to meeting federal and state requirements, issuers should analyze the costs and benefits of their proposed structures, which are highly dependent upon the reinvestment opportunities. Those who don't know in advance how they will invest this money should stop immediately and develop a reinvestment strategy:

o If you do not expect to earn positive arbitrage (if your yield on re-invested proceeds will fall below your borrowing rate), then you should borrow as little as possible for as short a period as possible.

o If you do expect to earn legally permissible positive arbitrage on your TRANs, then you will generally want to borrow as much as possible for as long as possible.

6. Credit is critical. Given the scarcity of affordable credit enhancements, ratings are more important than ever. In order to qualify as an eligible security for the money market funds (the primary investors of TRAN issues), municipal issuers must be categorized as "first tier" securities, which require the highest short-term ratings.

7. Explore available statewide "pools" vs. a standalone TRAN issue. In some states, the smaller localities have joined forces to issue pooled securities through a conduit borrower who acts on their behalf to make it easier to market their debt. They share costs and typically get the same interest rate. For smaller borrowers who lack access to the capital markets, this may be a viable strategy. For issuers that seek greater flexibility, have timing concerns or enjoy a stronger underlying credit, a standalone issue may make greater sense. And, some issuers of smaller amounts can sell their notes to a local bank and get a better tax-exempt rate.

8. Set aside money early. TRAN investors and rating agencies want to make sure that the money they lend you will be set aside to repay them once it becomes available -- no later than 30 days prior to the maturity date. You'll also be required to make a deposit with a third-party trustee or into segregated accounts to further protect these set-aside payments. Generally these set-asides are an accounting convention that provides added safety for investors; they may not require actual deposits.

9. Do your homework, and get expert help. The arbitrage rules are strict and complex, and the municipal securities market is facing an unfamiliar and ever-changing landscape. Even the most experienced municipal issuers surround themselves with people who do this work regularly, as the costs of an error can be severe and embarrassing.